Question

Consider a hypothetical closed economy in which households spend $0.60 of each additional dollar they earn and save the remaining $0.40.

The marginal propensity to consume (MPC) for this economy is   , and the spending multiplier for this economy is   .

Suppose the government in this economy decides to increase government purchases by $400 billion. The increase in government purchases will lead to an increase in income, generating an initial change in consumption equal to _________   . This increases income yet again, causing a second change in consumption equal to _______   . The total change in demand resulting from the initial change in government spending is _______.

Answer 1

$$ \begin{aligned} \text { Marginal propensity to consume } &=\frac{\text { Change in consumption }}{\text { Change in income }} \\ &=\frac{0.60}{1} \\ &=\$ 0.60 \end{aligned} $$

Calculate spending or expenditure multiplier:

$$ \begin{aligned} \text { Spending multiplier } &=\frac{1}{1-M P C} \\ &=\frac{1}{1-0.60} \\ &=\frac{1}{0.40} \\ &=\$ 2.5 \end{aligned} $$

The marginal propensity to consume for this economy is \(\$ 0.60\), and the spending multiplier is \(\$ 2.5\)

Suppose the government decides to increase government purchases by \(\$ 400\) billion. As there is an increase in government purchases there will be an increase in income.

An initial change in consumption is equal to \(\$ 400 \times 0.60=\$ 240\)

An increase in income again causes a second change in consumption equal to \(\$ 240 \times 0.60=\$ 144\)

Calculate the change in demand:

Change in demand= Government purchases \(\times\) multiplier

$$ \begin{array}{l} =\$ 400 \times 2.5 \\ =\$ 1,000 \end{array} $$

Therefore, the total change in demand resulting from the initial change in government spending is \(\$ 1,000\)